Sunday, June 17, 2012

Debt: the financial equivalent of the dark side of the force

Yesterday I wrote about interest rate arbitrage, or using debt for what amounts to financial jiu-jitsu. Today I want to write about how my views on debt have changed since I've adopted a more Mustachian outlook.

There is something satisfying about gaming the system with rewards credit cards, as Mr. Money Mustache and many others have written about. I like it because it feels like getting one over on those fat cat 1% bankers I keep hearing so much about. It's not for everyone, and I consider it the financial equivalent of playing with fire.

Then there are other forms of leverage. Almost every homeowner uses a mortgage. Just imagine, taking 20% of a house's value in cash and having someone else give you the remaining 80% so you can buy it. If you're in the real estate business you can use leverage to greatly increase the profitability of your invested capital a la The Aggressive Landlord in this MMM post.

Leverage increases your risk. Let's say you're leveraged 4-to-1 on your house (25% down, and let's say it's a rental house so it counts as an investment). If housing prices go up by 10%, awesome! that's 40% profit! But what if housing prices drop by 10%? Crap, there goes 40% of your equity. Wall Street investment banks use massive amounts of leverage, sometimes in the ballpark of 100-to-1, to greatly increase their potential profits and endanger the health of the global financial system while they're at it. (See, for example, the history of Long-Term Capital Management).

Using debt is the quicker, easier, more seductive side of personal finance. I'd be lying if I said I wasn't tempted. I've even been engaging in some debt-fueled risky business per yesterday's post. But I've decided that my ultimate goal is to lead a debt-free lifestyle, even if it means foregoing lucrative financial opportunities like investing in rental properties.

Warren Buffett famously eschewed debt over his many years of investing. (I read his biography, it's a great read and totally worth the length). When he was in his twenties and thirties he had dozens of partnerships and knew about hundreds of insanely profitable investment opportunities. He was consistently cash-starved up until the 80s (I think) in that he always had many more good investments than cash to buy them with. But he would never take on debt to pursue those investments, no matter how much of a sure deal they were. His brand of long-term investing requires that he always stays solvent, no matter how irrational the market is. Having to make a margin call even once would have cost him billions.

I like the principled stand of no debt, only equity. There is an oldschool feel about it. If you don't have a mortgage then the bank can't foreclose on your farm, no matter how bad this year's crop has been.

I'm already committed to paying down my student loans. After that, I'm thinking of winding down every other debt I have. Right now that's the mortgage, the 0% credit card debt, and the 401k loan. Soon it will include a used car loan (more on that later, it's not as bad as it sounds). That's a lot of debt, especially the mortgage, and I need to decide how aggressive I'll want to be in paying it down. I do want to pay it down, though, all of it, that's what I've decided. I want to live the equity-only lifestyle.

The allure of leverage isn't going to go away. But avoiding temptation is future Mustachian Acolyte's problem. Right now I'll keep putting one financial foot in front of the other.

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